2023 Mid-Year Outlook: Fixed Income

June 7, 2023 Kathy Jones
Despite high volatility in the bond market during the first half of the year, what's surprising is how much didn't change.

It hasn't been an easy start to the year for bond investors. The Federal Reserve continued its aggressive pace of rate hikes; instability flared in the banking sector, requiring government intervention; and a tense battle over raising the debt ceiling led to heightened fears that the U.S. government might default. Not surprisingly, volatility in the bond market—which is a measure of the degree of uncertainty about the direction of interest rates—soared.

Bond market volatility was high during the first half of the year

Chart shows the MOVE index dating back to 2006. The MOVE Index, which measures bond market volatility, rose sharply during the 2007-2008 financial crisis, at the beginning of the COVID-19 pandemic in 2020, and has been elevated since 2022.

Source: Bloomberg. ICE BofA Move Index (MOVE INDEX).

Daily data as of 6/6/2023 Past performance is no guarantee of future results.

The MOVE index is a market-implied measure of bond market volatility. The MOVE index calculates the implied volatility of U.S. Treasury options using a weighted average of option prices on Treasury futures across multiple maturities (2, 5, 10, and 30 years).

Yet as we close the books on the first half of 2023, what stands out is how much didn't change. Short-term yields have pushed higher as the Fed tightened policy, but yields for Treasury securities maturing in two years or more are nearly unchanged.

Yields for Treasury securities maturing in two years or more are nearly unchanged

Chart shows the yield to maturity for a range of Treasury securities from three months to 30 years, as of June 6, 2023, and as of December 30, 2022. Although short-term yields are higher now than they were in December 2022, yields for securities maturing in two years or more are largely the same.

Source: Bloomberg US Treasury Actives Curve, as of 6/6/2023 and 12/30/2022.

Past performance is no guarantee of future results.

The yield curve remains inverted, but the spread between 2-year and 10-year Treasury yields has stabilized in a range after plunging to its deepest level in decades.

The 2-year/10-year yield curve is still inverted, but has stabilized

Chart shows the 2-year vs. 10-year Treasury yield curve dating back to 2003. Although the yield curve remains inverted, it has stabilized and was at negative 83 as of June 6, 2023.

Source: Bloomberg. Market Matrix US Sell 2 Year & Buy 10 Year Bond Yield Spread (USYC2Y10 INDEX). Daily data as of 6/6/2023.

This spread is a calculated Bloomberg yield spread that replicates selling the current 2 year U.S. Treasury Note and buying the current 10 year U.S. Treasury Note, then factoring the differences by 100. A basis point is one hundredth of one percent, or 0.01%. Gray shaded bars represent recessions. Past performance is no guarantee of future results.

Despite all the turmoil in the market, year-to-date returns have been positive in nearly every sub-asset class of the fixed income market. Short-term investments with low durations posted modest gains, while intermediate to long-term bonds benefited from higher starting coupons and a downward drift in yields.

Year-to-date returns have been positive so far this year

Chart shows year-to-date returns for a variety of fixed income asset classes, led by preferred securities, which were up 4.7% as of June 5, 2023. High-yield corporates total return was 4.7%, Treasuries total return was 2% and international developed market bonds ex-U.S. were up 0.7%.

Source: Bloomberg. Total returns from 12/31/2022 through 6/5/2023.

Total returns assume reinvestment of interest and capital gains. Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly. Indexes representing the investment types are: Preferreds =  ICE BofA Fixed Rate Preferred Securities Index; HY Corporates = Bloomberg US High Yield Very Liquid (VLI) Index; Bank Loans = Morningstar LSTA US Leveraged Loan 100 Index; Long-term US Agg = Bloomberg U.S. Aggregate 10+ Years Bond Index; IG Floaters = Bloomberg US Floating Rate Note Index; IG Corporates = Bloomberg U.S. Corporate Bond Index; US Aggregate =  Bloomberg U.S. Aggregate Index; Intermediate-term US Agg = Bloomberg U.S. Aggregate 5-7 Years Bond Index; Municipals = Bloomberg US Municipal Bond Index; Treasuries = Bloomberg U.S. Treasury Index; EM (USD) = Bloomberg Emerging Markets USD Aggregate Bond Index; Securitized = Bloomberg US Securitized Index; Agencies = Bloomberg U.S. Agency Bond Total Return Index; TIPS = Bloomberg US Treasury Inflation-Protected Securities (TIPS) Index; Short-term US Agg = Bloomberg U.S. Aggregate 1-3 Years Bond Index; Int. developed (x-USD) = Bloomberg Global Aggregate ex-USD Bond Index. Past performance is no guarantee of future results.

Federal Reserve policy outlook: Suddenly, then gradually

The Fed continues to follow its "hike and hold" strategy to fight inflation. It raised rates rapidly over the last year, bringing the fed funds target rate to 5.0% to 5.25%, the highest level since 2007. In the second half of the year, the Fed is signaling it will likely shift to holding rates steady and only increase them gradually if inflation remains persistent.

The shift to a more gradual tightening stance reflects growing confidence that policy is succeeding. Economic growth is slowing, and inflation is easing. Gross domestic product (GDP) growth has averaged less than 1.5% over the past four quarters, the manufacturing sector appears to be in recession, and housing activity has fallen sharply. The service sector has proven more resilient, but the pace of growth is easing.

The ISM services report indicates that growth in nearly every segment of the sector is slowing

Chart shows the ISM services index and three of its underlying components, new orders, prices and employment dating back to May 2017. All have turned lower in recent months and some are below the index level of 50. An index reading above 50 indicates an expansion in activity and below 50 indicates a decline in activity.

Source: Bloomberg, Institute for Supply Management. Monthly data as of 5/31/2023.

ISM Services PMI (NAPMNMI Index), ISM Services PMI Business New Orders (NAPMNNO Index), ISM Services PMI Business Prices (NAPMNPRC Index), ISM Services PMI Business Employment (NAPMNEMP Index).

On the inflation side, a key concern has been the strength in wage growth, which the Fed believes can contribute to inflation, becoming embedded. The recent trend indicates that wage pressures from a tight labor market appear to have peaked. Average hourly earnings are running at a 4.3% pace compared to a peak of almost 6% late last year, indicating that the supply of labor is beginning to balance out with demand after the pandemic-related shortages. Wage growth is probably still too high for the Fed's comfort level. A growth rate that prevailed prior to the onset of the pandemic of about 2.5% to 3.0% would likely be seen as pointing to a stable inflation outlook.

Average hourly earnings have declined

Chart shows monthly average hourly earnings and the three-month moving average. Both have declined during the past year.

Source: Bloomberg, using monthly data as of 5/31/2023.

US Average Hourly Earnings All Employees Total Private Yearly Percent Change SA (AHE YOY% Index).

Holding is tightening

While the Fed may cease or slow its rate hikes, it is still in tightening mode. The federal funds rate is higher than the current rate of inflation as measured by the Fed's preferred indicator, the core personal consumption expenditures (PCE) index. Policy is now in the restrictive range, which should mean slower growth and lower inflation ahead. Real yields—that is, yields adjusted for inflation expectations—are at the highest levels in years, making it more expensive to borrow for investment or consumption. This is the point of tight monetary policy: to reduce inflation by slowing down the economy.

Real yields haven't been this high in more than a decade

Chart shows the real 10-year Treasury yield, which was at 148 basis points as of June 6, 2023, and the real 5-year Treasury yield, which was at 169 basis points as of June 6, 2023.

Source: Bloomberg, daily data as of 6/6/2022.

US Generic Govt TII 10 Yr (USGGT10Y INDEX), US Generic Govt TII 5 Yr (USGGT05Y INDEX). Past performance is no guarantee of future results.

However, the Fed won't likely switch to rate cutting until inflation is closer to its 2% target. Based on its benchmark measure—the price index for personal consumption expenditures excluding food and energy—there is still a long way to go, and it has been stuck near 4.5% for several months.

The good news is that the "stickiness" in inflation is now confined to a smaller number of categories compared to earlier in the year. In recent months three categories largely accounted for above-average inflation—housing, financial services and used cars. As the categories of price inflation narrow, the overall trend will likely improve.

The New York Federal Reserve Bank recently published a way to measure the "persistence" of inflation. Its model suggests that inflation pressures may ease later in the year. Of course it's just a model, and the Fed isn't likely to weigh it heavily in their decision making, but it's suggesting the trend is lower.

Persistent inflation appears to be easing

Chart shows headline PCE, core PCE and the multivariate core trend dating back to 2017. All have declined since 2022.

Source: Bureau of Economic Analysis (BEA). Monthly data as of 4/30/2023.

Headline PCE: PCE is Personal Consumption Expenditures Chain Type Price Index YoY and (PCE DEFY Index) and Core PCE: Core Personal Consumption Expenditures Chain Type Price Index YoY (PCE CYOY Index).

PCE is personal consumption expenditure. The Multivariate Core Trend (MCT) is a dynamic factor model estimated on monthly data for the seventeen major sectors of the PCE price index. It decomposes each sector's inflation as the sum of a common trend, a sector-specific trend, a common transitory shock, and a sector-specific transitory shock. The trend in PCE inflation is constructed as the sum of the common and the sector-specific trends weighted by the expenditure shares.

The Fed is also continuing to tighten monetary policy by allowing the size of its balance sheet to shrink as the bonds on its balance sheet mature. All indications are that the plan is to let the process continue even if rate hikes end.

Rate hikes: Stop, skip, jump?

There is a lot of speculation about the Fed's moves in the second half of the year. If rate hikes are paused, does that imply the cycle is over … or is it just "skipping" a meeting and then resuming hikes? Or will the Fed actually need to increase the size of its rate hikes—a jump—to catch up to inflation?

We look for the Fed to keep its policy stance largely on hold in the second half of the year, although one more rate hike is possible. A shift to easing policy would only likely be seen if the economy were to fall into recession or if financial stability issues were to re-emerge. Overall, we believe the federal funds rate is at or near its peak for this cycle and that intermediate to long-term rates peaked last fall.

Because the economy responds to changes in Fed policy with a lag, the risks to growth and inflation appear skewed to the downside after more than a year of tightening policy. Moreover, fiscal policy has gone from a positive factor for the economy to a negative one. The "fiscal impulse," which measures the contribution of fiscal policy to GDP growth, has shifted to a slight negative after surging during the pandemic.

Fiscal policy is a net negative for the economy as pandemic era stimulus fades

Chart shows the quarterly impact of fiscal policy dating back to the year 2000, as well as projections for the remainder of 2023, 2024 and 2025. Gray shaded bars represent past recessions.

Source: Brookings, The Hutchins Center Fiscal Impact Measure. Bureau of Economic Analysis (historical) and the Congressional Budget Office (projections).

Quarterly data as of Q1 202; projections begin Q2 2023.

The Hutchins Center Fiscal Impact Measure shows how much local, state, and federal tax and spending policy adds to or subtracts from overall economic growth and provides a near-term forecast of fiscal policies' effects on economic activity. When Fiscal Impact is positive, the government is contributing to GDP growth. When fiscal impact is negative, government is subtracting from GDP growth. Gray shading indicates past recessions.

The second half outlook: More of the same

In the second half of the year, we look for bond yields to continue to decline. The forces that have been pulling them lower—tightening monetary and fiscal policies—should continue. Treasuries with maturities of two years or longer likely will continue to decline. We expect to see 10-year Treasury yields fall to the 3.0% to 3.25% level by year-end. The yield curve will likely remain inverted until there is a signal that the Fed is shifting to easier policy.

Our guidance for investors is the same as it has been since late last year: Consider adding some intermediate-term or longer-term bonds to portfolios gradually, and stay in higher-credit-quality bonds. While it may be tempting to stay in very short-term investments due to risk-free yields at 5% or higher, that opens investors up to reinvestment risk—the risk that they will have to reinvest maturing securities when yields are lower.

With current yields in the region of 4% to 5% for high-credit-quality bonds such as Treasuries, other government-backed bonds, and investment-grade corporate and municipal bonds, we think it makes sense to lock in those cash flows with certainty rather than risk reinvesting maturing short-term bonds into lower yields once the Fed begins to cut interest rates.

Moreover, there is also likely potential for capital gains for investors with shorter time horizons. In past cycles, the total return for intermediate-term bonds has been higher than in short-term in the 12 months following the peak of the fed funds rate.

Returns for intermediate-term bonds have outpaced short-term bonds after the peak in the fed funds rate

Chart shows the total return for short-term and intermediate-term bond indices during the 12 months following the peak federal funds rate in February 1995, March 1997, May 2000, June 2006 and December 2018. In all instances, the intermediate-term index outperformed the short-term index.

Source: Bloomberg.

Short-term = Bloomberg U.S. Aggregate Bond Index 1-3 year Total Return Value Unhedged USD. Intermediate-term = Bloomberg U.S. Aggregate Bond Index 5-7 year Total Return Value Unhedged USD. Chart shows 12-month total returns for each period from the peak month of the federal funds rate. Past performance is no guarantee of future results.

While our expectation is that inflation will recede, many investors remain concerned about inflation. In that case it might make sense to consider Treasury Inflation Protected Securities (TIPS) as an alternative or in addition to nominal Treasuries. Yields are roughly 1.5% or more in real terms. That means that an investor who holds to maturity can expect to receive the real rate plus the rate of inflation based on the consumer price index (CPI). Consequently, if inflation does prove more persistent than current trends suggest, TIPS can offer investors a way of mitigating that risk in their bond portfolios.

In sum, we look for returns in the second half of the year to be positive even if Federal Reserve policy stays the same as it has been in the first half. We're just hoping for a lot less volatility along the way.

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